The Ultimate Guide to Reverse 1031 Exchanges

The 1031 exchange, named after section 1031 of the Internal Revenue Code (IRC), is quite possibly one of the most important tools for real estate investors and business owners.  It is seen by many as penultimate reason to invest in real estate, as the 1031 exchange can effectively allow you to defer your taxes on your capital gains indefinitely in many cases.  

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While most people are familiar with the traditional, “forward” 1031 exchange, many are not familiar with the reverse 1031 exchange, also known as simply, the reverse exchange.  The reverse exchange is a powerful tool that investors can leverage when a traditional 1031 exchange won’t work for them.  

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In this article, we’ll delve deep into reverse 1031 exchanges, covering everything you need to know about what they are, how they work, how they differ from forward exchanges, and how they might benefit you and your real estate investing strategy.

What is a Reverse 1031 Exchange?

A reverse 1031 exchange is a variation of the traditional, “forward” 1031 exchange, with one key difference.  In a forward exchange, you purchase the replacement property after you relinquish your existing property.  However, with a reverse exchange, the replacement property is acquired prior to the sale of your existing property.  This is incredibly helpful, especially if a deal you just can’t pass up comes on the market before you’re ready to list your existing property.  

However, as you might expect, with a reverse 1031 exchange, things are a bit more tricky than they are with a forward exchange.  There are additional parties involved in the transaction, and the timelines set forth by the Internal Revenue Code work slightly differently.  This means it’s important to not only educate yourself on the nuances of a reverse 1031 exchange, but it’s also important to partner with a QI that has extensive experience with facilitating reverse exchanges, like Deferred.  

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When Should You Consider Using a Reverse 1031 Exchange

Although reverse 1031 exchanges are a fantastic tool to have in your tool belt, they’re not the best tool for every situation.  As we alluded to in the previous section, reverse 1031 exchanges are most commonly used when you want to complete the purchase of your new replacement property before selling your old relinquished property. It’s a way to complete an exchange when an opportunity you simply can’t pass up comes across your desk and you need to move quickly with a purchase. 

In this situation, if you were to do a forward exchange, you’d have to wait for your current property to sell. There’s a good chance you could miss out on the opportunity, as too much time would pass, and someone else would likely scoop up the deal before you. 

However, since a reverse exchange allows you to purchase the replacement property prior to selling your current property, it’s the perfect tool for the job, especially if you’re in a very competitive market!  

This also means you have a bit more time to work with when it comes to selling your existing property, allowing you to get top dollar for your current property!  Additionally, if you’re planning on making improvements or renovations to your replacement property, you can start on these right away, before the exchange is complete.  This can be especially helpful if the property is in need of a little TLC to maximize the value.  

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How Does a Reverse 1031 Exchange Work?

The reverse exchange process starts when an investor identifies a property that they would like to purchase and use as their replacement property.  The investor works together with a Qualified Intermediary, like Deferred, to set up an entity that will act as the Exchange Accommodation Titleholder, and enter into a Qualified Exchange Accommodation Arrangement with the investor.  

An Exchange Accommodation Titleholder (EAT) is a special role for Reverse Exchanges. It allows for a Qualified Intermediary to “park” the replacement property in a legal entity, like an LLC, and hold title on the investor’s behalf while they complete the sale of their relinquished property. 

The Qualified Exchange Accommodation Arrangement, or QEAA, is the agreement that the investor and the Qualified Intermediary sign so the structure of the reverse exchange is clear.  

The Qualified Intermediary will then use funds provided by the investor to acquire the replacement property.  This is often referred to as a “parking” arrangement, which allows the investor to acquire the property without violating IRS rules regarding ownership throughout the exchange process.  

Once the replacement property is acquired, the investor then has 180 days to sell their existing property.  After the relinquished property is sold, the EAT then transfers the title of the replacement property to the investor.  This marks the completion of the reverse 1031 exchange.  

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The Role of a Qualified Intermediary in a Reverse 1031 Exchange

In any form of 1031 exchange, including reverse exchanges, qualified intermediaries play a pivotal role in the transaction.  They work to facilitate the exchange, and they ensure that the exchange adheres to the strict guidelines set forth by the IRS.  As with a forward exchange, in a reverse exchange, the QI will work to coordinate the process, manage the flow of funds, and work to maintain the integrity of the exchange.  

The QI will work as a neutral third party who holds and transfers funds for the investor, taking proper caution to avoid constructive receipt of any funds.  This is because, if the investors were to receive (or have constructive receipt of) any funds from the sale of the relinquished property prior to the closure of the exchange, the transaction would be disqualified from any tax deferral benefits.  

The QI will also either work as the EAT, or work closely with a third party EAT to ensure that each step of the exchange is executed properly, in adherence to the very specific guidelines set forth by the IRS.  When working with the EAT, they will help draft necessary legal documents, manage the timelines for the exchange, and coordinate the sale and transfer of property titles.  

Since reverse exchanges are a bit more complicated and tedious than forward exchanges, it’s important to work with a QI that has experience with reverse exchanges, like Deferred.  When working with a QI that has extensive experience with reverse exchanges, you’ll navigate the intricate process easily, while ensuring that the transaction is in compliance with IRS regulations.  This, of course, will reduce the risk of costly mistakes, which could put your tax-deferral benefits in jeopardy.  

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The Importance of an Exchange Accommodation Titleholder (EAT) in a Reverse 1031 Exchange

One key area where reverse exchanges differ from forward exchanges is in the use of an exchange accommodation titleholder.  This is an entity that isn’t present during a forward exchange, but plays a tremendously important role in a reverse exchange.  As we mentioned in our previous sections, the EAT in your exchange could be your QI, or a third party, depending on the QI that you’re working with.  

The EAT plays a pivotal role in the exchange, ensuring that the investor does not hold the title of both the relinquished property and the replacement property at the same time.  If the investor were to hold both titles at once, they would lose all tax-deferral benefits.  To avoid this, the investor “parks” the replacement property with the EAT until the sale of the relinquished property is completed.  

However, an EAT can’t be just anyone.  Much like your QI, your EAT needs to be a separate entity from the investor, and cannot be someone who has a relationship with the investor.  This means that your EAT cannot be a business partner, employee, or relative.  The term business partner is very broad too - your trusted attorney or accountant cannot act as your EAT either.  This regulation is set forth to ensure that there are no conflicts of interest in the deal.  

Having an EAT involved in the transaction adds a bit of financial complexity to the puzzle though, as they are technically still required to pay for any property expenses, including taxes and other liabilities associated with the property.  The great part about this though is that even though the EAT is holding the title to the replacement property, you can still make repairs or improvements to the property before you officially acquire it.  This means you can have the property in tip-top shape when you officially take possession of it.  

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Understanding the Rules for a Reverse 1031 Exchange

As with any type of 1031 exchange, there are very rigid rules set forth by the IRS that govern the reverse exchange.  The two most prominent rules are regarding ownership of the property, and the timeline that the transaction must be completed within.  

When it comes to ownership of the property, the investor cannot have possession of both the relinquished property and the replacement property at the same time.  This, of course, is why there is an EAT to help facilitate the transaction.  

In terms of timing, there are two prominent rules that govern the reverse 1031 exchange.  The first of which is the 45 day rule.  This rule states that the investor has 45 days to identify which property is being relinquished (sold), once the EAT takes possession of the replacement property.  When identifying the relinquished property, the investor needs to provide specific details about the property, including the exact address and a description of the property.

The second rule around timing is the 180 day rule, which states that the reverse exchange must be completed within 180 days from the date the EAT takes possession of the title to the replacement property.  Having the reverse exchange “completed” means that the relinquished property must be sold and the replacement property must be transferred to the investor.

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How Does a Reverse 1031 Exchange Differ from Other Types of Exchanges?

In order to employ the proper type of 1031 exchange, it’s important to know about all of the types of exchanges that are out there.  Aside from reverse exchanges, the other two main types of 1031 exchanges are forward exchanges and construction exchanges.  In order to help you decide which type of exchange is best for you, we’ve compared the other two types of exchanges below.

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Reverse vs. Forward 1031 Exchange

The primary difference between forward and reverse exchanges is the order in which they’re completed.  In a forward exchange you sell your existing property prior to purchasing the replacement property, and in a reverse exchange, the process is, well… reversed!  

Reverse exchanges are great for those who suddenly have a deal come across their desk, and need to act quickly.  Whereas, forward exchanges work better for those who can sell their relinquished property first - you many not have a specific replacement property in mind yet, or have a closing date for the replacement property that is after the sale date for your old property.  

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Reverse vs. Construction 1031 Exchange

A construction exchange is similar to a forward exchange, except some of the proceeds of the sale of the relinquished property can be used to make improvements to the property.  This is especially helpful if you’re eyeing a replacement property that has a lower value than the relinquished property, but needs quite a bit of work.  

The only caveat is that funds can only qualify for tax deferral if improvements are paid for within the 180 day window.  This means you have roughly 6 months to both identify a property, close on it, and make improvements to it, which can be especially difficult!  However, if you’re looking to invest in a property that requires a considerable amount of repairs/improvement, this might be the right exchange for you.

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The Benefits of a Reverse 1031 Exchange

The benefits of a reverse 1031 exchange are twofold.  The first and most obvious benefit of a reverse 1031 exchange is that you can defer tax liabilities with them.  After all, the 1031 exchange is what makes real estate one of the best investment classes in the United States.  

Additionally, when you employ a reverse 1031 exchange, you can take advantage of all of the tax benefits of a 1031 exchange, without letting a deal pass you by.  Being able to purchase your replacement property prior to selling your existing property is an incredibly powerful tool to have in your tool belt, especially for those in more competitive markets.  

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The Challenges and Risks Associated with a Reverse 1031 Exchange

As with anything in business, there are both challenges and risks associated with a 1031 exchange.  While many of them can be mitigated, it’s important to know what they are before you make any moves.  

Quite possibly the biggest challenge of a reverse 1031 exchange is the complexity of the process.  It’s a daunting process for those who are newer to the real estate investing world, or those who haven’t done a 1031 exchange before.  There are a lot of moving parts, and quite a few players involved in the process, which can be a bit overwhelming at times.  However, this can be mitigated by working with a team of 1031 exchange professionals, like the ones at Deferred.

Another risk is the financing of the deal itself.  Reverse exchanges require an investor to have either the capital or the financing in place for the replacement property, without leveraging the proceeds of the relinquished property.  This means you either need to have a lender that’s willing to work with you, or the capital to cover the transaction in place, which can be a tall order for some. In some cases, a Qualified Intermediary may be able to help arrange financing, but it’s not a given and may come with a premium. 

Lastly, as with any type of 1031 exchange, the timelines you’re required to meet can present a challenge as well.  Although it’s certainly possible to complete a reverse exchange in 6 months, the real estate world is often slow moving and clunky, which can lead to hiccups and set backs.  When doing a reverse exchange, you can’t afford many of these setbacks. A simple delay in closing the sale of your relinquished property could put you beyond the 180 day timeline and put the tax-deferability of the transaction at risk. 

Partnering With Deferred for Your Reverse 1031 Exchange

If you’re considering a reverse 1031 exchange, partnering with a seasoned qualified intermediary is key.  After all, a qualified intermediary act as the facilitators of the exchange, ensuring that everything moves according to schedule, in adherence with the guidelines set forth in the IRC.  They play a key role in ensuring the success of your 1031 exchange.

When you partner with Deferred or one of our experienced and knowledgeable partner Qualified Intermediaries (QIs), you can trust that you're working with professionals dedicated to ensuring a smooth and successful 1031 exchange process. Our in-house and partner QIs adhere to the highest standards and have a proven track record of handling a diverse range of 1031 transactions.

From straightforward forward exchanges to intricate construction exchanges and everything in between, we have extensive experience in navigating the complexities of 1031 exchanges. Our team is equipped to guide you through each step of the process, ensuring compliance with IRS regulations and maximizing the benefits of your exchange.